The overreaction heard 'round the world

The overreaction heard 'round the world

June 26th, 2013by Christopher A. Hopkins CFA
in Business Diary

Chris Hopkins

Chris Hopkins

Photo by
Patrick Smith
/Times Free Press.

Global markets have stumbled this past week in response to the most widely expected and unsurprising event of the year. Last Wednesday, the Federal Open Market Committee announced (fanfare please): current policy will be maintained, unless something changes that requires a different policy.

That's it. That was the extent of the official release, followed by a press conference held by the Fed chairman during which he also reiterated the status quo, barring new information that might necessitate changes.

Pretty strong stuff. In response, the U.S. stock market entered a selloff that continued into this week as investors contemplated the horrific possibility that interest rates might someday move back in the general direction of normal. Bond markets freaked out even more, as the yield on the 10-year U.S. Treasury bond surged past 2.60 percent for the first time since August of 2011. Never mind that 2.60 percent in 2011 was the lowest rate in modern history going back before the Kennedy administration.

All in all, the markets overreacted, probably thanks to some professional investors using the non-event as an excuse to take some profits off the table after riding the stock market rocket 22 percent higher since November. Some consolidation of the relentless gains was long overdue, and the Fed decision provided the opportunity to pare down winning positions.

So why did the Fed pronouncement raise everyone's hackles? First we need to understand just how far the central bank has come.

The Federal Reserve is assigned the task of stabilizing the banking system in times of crisis by providing "liquidity"; that is, flooding the banking system with dough. It is now self-evident that they did their job well during the heat of the financial crisis.

Subsequently, the Fed has focused attention on its other congressionally mandated imperative, stimulating full employment. This the Fed has addressed by holding interest rates down and engaging in a buying spree of mortgage-backed securities from Fannie and Freddie, and by gobbling up over half the new U.S. Treasury bonds issued since 2012.

Now that the crisis is past and there is evidence of slow but steady improvement in employment, markets have begun to obsess over when the cheap money gets withdrawn. Last week's policy statement essentially repeated the previous one: the stimulus will continue until no longer needed, with any luck sometime later this year. Even then, it will not be summarily curtailed but gradually and incrementally decreased ("tapering" is the phrase of the week). Meanwhile, the unprecedentedly low interest rates should be expected to continue well into at least 2014. Hardly the Apocalypse.

Financial journalists (with nothing else to worry about) have been almost deliberately obtuse in their reporting of Chairman Bernanke's statements, wringing their hands over exactly what date and exactly how much tapering will occur. Lost in all of this consternation is the underlying reason why the members of the Fed are contemplating a reduction in emergency operations: it looks to them that the economy is getting better. And that is good news.